The role of gold, part 1: Modern portfolio diversification

by Flexible Plan Investments, Ltd.Apr 3, 2014Industry insights

The role of gold, part 1: Modern portfolio diversification

by Flexible Plan Investments, Ltd.Apr 3, 2014Industry insights

New analysis supports optimal portfolio allocation to gold of 20%.

Editor’s note: A revised and updated version of this article can be found here.

Even the most ardent supporters of portfolio and investment management theory have had belief systems shaken to the core over the past 15 years. With all of the “boom-and-bust” volatility and unprecedented global systemic risk, both traditional advisors and individual investors have been forced to reevaluate approaches to risk management and consider new alternatives in portfolio construction.

One thing is certain: In changing market environments, it has become imperative to develop a portfolio approach that minimizes drawdowns and volatility while delivering respectable returns, all within an individualized investor risk profile.

Perhaps nowhere has the debate raged more fiercely than in consideration of alternative asset classes, especially the role of commodities and precious metals, and most notably gold. Many traditional wealth and portfolio managers will begrudgingly acknowledge that gold should play a role in investors’ portfolios, but frankly the rationale can be quite thin and more instinctual than empirical.

This article, the first in a two-part series, will present a brief overview of gold’s performance during various market and asset-class scenarios. Part II will review gold’s performance during several broad economic regimes and outline the tangible benefits of portfolio diversification with gold, revealing some eye-opening data that suggests a much more important role for gold in portfolios.

40 years of asset-class data

A recent quantitative analysis by Flexible Plan Investments of gold in different economic and market regimes demonstrates that gold has been valuable for investors as both an alternative source of return and also as a hedge. Contrary to conventional wisdom, the study finds that over the period from 1973 to June 2013, the efficient allocations to gold for a typical balanced investor ranged from 5% to 45%, depending on the desired risk preference. In fact, the analysis supports an optimal portfolio allocation of 20% to gold in the traditional 60/40 balanced portfolio.

One of the underpinnings of why gold can play such an important role in portfolio construction is in understanding gold’s historical performance compared to other asset classes and under various market conditions.

Let’s first look at the annualized rate of return of various asset classes from 1973 to June 2013 in the following figure.

Overall Performance of Various Asset Classes

(1973-6/30/13)

As shown, equities have been the best-performing asset class throughout this period, closely followed by gold. But equity performance has been far from a “smooth ride” for the past several decades. In contrast, gold’s equally bumpy journey has demonstrated a unique ability to outperform equities in times of market stress and also under a wide variety of different economic conditions.

The study examined the performance of gold relative to other asset classes under seven different conditions, with the following conclusions.

Scenario #1: Negative Treasury bond real returns

Gold is the best performing of all major asset classes, delivering nearly 18% annual returns when real Treasury returns were negative, while equities performed at a rate about one-third that of gold.

Scenario #1: Performance of various asset classes when real rates are negative

(1973-6/30/13)

Scenario #2: Bear markets in stocks

Gold outperformed all other asset classes during periods of equity market stress, where equities declined over 20%. Its historical compound return during major stock declines has been surprisingly higher than the return of Treasuries, delivering close to a 19% annualized return versus 14.5% for Treasuries. This disparity arises because gold offers inflationary protection as well as crisis protection.

Scenario #3: Commodity bull markets

Although gold provided positive returns during equity bear markets, other commodities generally performed negatively. However, gold nearly matched the performance of commodities (at 22%) themselves during bull markets in commodities. It thus behaved well on its own and as a useful complement to broader commodity exposure.

Scenario #4: U.S. dollar bear markets

There can be any number of reasons for a U.S. dollar bear market, ranging from trade and budget deficits to monetary policy decisions. The data showed that gold performed extremely well (up 26.5%), and significantly outperformed all other asset classes, when the U.S. dollar fell. Gold is considered to be the currency of last resort by many investors.

Scenario #5: U.S. Treasuries in a bear market

U.S. Treasuries reflect lower prices when interest rates are rising and yields increase. Gold has historically offered the best returns under such a scenario, even outperforming equities.

Scenario #5: Performance of Various Asset Classes in Treasury Bear Markets

(1973-6/30/13)

Scenario #6: Inflation is rising

Gold has historically superior performance when there was a sustained increase in the general level of prices for goods and services. Within this type of environment, the U.S. dollar clearly weakened, in both “price” and purchasing power, while gold outperformed all other asset classes (even a basket of commodities).

Scenario #7: Periods of high market volatility

Treasuries performed best when volatility was high, as investors tended to “run for the safety” of preserving principal. But gold also performed very well, averaging a 7.6% annualized return and serving as a useful “crisis” hedge for investment portfolios.

***

To summarize, over the last 40 years, gold has ranked #1 or #2 under seven challenging market conditions:
• Negative Treasury bond real returns: 17.5% return
• Bear markets in stocks: 18.8% return
• Commodity bull markets: 22.2% return
• U.S. dollar bear markets: 26.5% return
• U.S. Treasuries in bear markets: 17% return
• Rising inflation: 10.1% return
• Periods of high market volatility: 7.6% return

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.

This article presents an excerpt from a Flexible Plan Investments, Ltd., white paper titled “The Role of Gold in Investment Portfolios” by authors David Varadi, Jerry Wagner, and David Wismer. The complete paper—including a list of source data and an appendix on the quantified definition of bull, bear, and sideways markets—can be found at http://www.goldbullionstrategyfund.com.

Past performance does not guarantee future results. Inherent in any investment is the potential for loss as well as profit. A list of all recommendations made within the immediately preceding 12 months is available upon written request.

This white paper is provided for information purposes only and should not be used or construed as an indicator of future performance, an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Flexible Plan Investments, Ltd., cannot guarantee the suitability or potential value of any particular investment. Information and data set forth herein has been obtained from sources believed to be reliable, but that cannot be guaranteed. Before investing, please read and understand Flexible Plan Investments, Ltd., ADV Part 2A and Part 2A Appendix 1.

Since 1981, Flexible Plan Investments (FPI) has been dedicated to preserving and growing wealth through dynamic risk management. FPI is a turnkey asset management program (TAMP), which means advisors can access and combine FPI’s many risk-managed strategies within a single account. FPI’s fee-based separately managed accounts can provide diversified portfolios of actively managed strategies within equity, debt, and alternative asset classes on an array of different platforms. FPI also offers advisors the OnTarget Investing tool to help set realistic, custom benchmarks for clients and regularly measure progress. flexibleplan.com

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